The Motley Fool

Encana Corporation: Should Investors Buy or Bail Out?

Oil prices appear to be stabilizing near $60 and natural gas might have found a bottom. Does this mean you should back up the truck and buy shares of Encana Corporation (TSX:ECA)(NYSE:ECA) to get ahead of a rally?

Probably not, and here’s why.

Caught in transition

Encana is in the middle of a large transition, switching from being a natural gas company to one focused on liquids production.

When management first made this decision the market supported the plan, but that was back in the days when crude fetched $100 per barrel.

The company sold off gas assets at low prices and then made a huge US$7.1 billion bet to acquire Athlon Energy. That decision continues to weigh heavily on the balance sheet and the fallout has been painful for shareholders.

Last June Encana traded for $26 per share. The current price is below $16.

Operational improvements

Despite the unfortunate timing of the transition, Encana is making progress on its plan. Cash flow in Q1 2015 increased by 31% over Q4 2014, driven by a 13% gain in liquids production.

The company is getting strong operational performance out of its four key assets located in the Montney, Duevernay, Eagle Ford, and Permian plays. Margins from these locations are better than those delivered by the entire portfolio in 2013 when Encana began its major transition.

Cash flow

Encana’s guidance for 2015 is based on an average WTI price of $50 per barrel (bbl) and an average NYMEX natural gas price of $3 per million British thermal units (MMBtu). Oil is trading considerably higher than the target number, but natural gas is currently below $2.70/MMBtu.

The company expects 2015 cash flow to be $1.4-1.6 billion. Capital expenditures are targeted at $2-2.2 billion.

Encana plans to use the proceeds from asset sales to fill the funding gap and cover the dividend payment. Normally, that is not a long-term recipe for success. The company currently pays out $52 million in dividends each quarter.

Balance sheet

Encana finished the first quarter with cash and cash equivalents of about $2 billion, as well as $2.6 billion in available credit facilities, which means there is no threat of a cash crunch in the near term.

In March it raised $1.44 billion through a bought-deal share offering and used the money to reduce debt. As of March 31 Encana still had $5.9 billion in outstanding long-term debt.

The company has to maintain an adjusted debt-to-capitalization ratio of less than 60%. That number was 29% at the end of the first quarter, so things would have to deteriorate significantly for the covenants to be breached.

Should you buy Encana?

Buying any oil producer requires a belief that crude prices have bottomed. Analysts are all over the map when it comes to year-end targets on the commodity, so the sector still looks volatile.

Encana’s cash flow still isn’t covering expenditures and prices will have to improve significantly from current levels for that to happen. The company estimates that every additional $10 increase in the price of oil adds about $55 million to quarterly cash flow. If oil rises another $10 per barrel, the company can at least pay the dividend, but the capital shortfall will still have to be covered using cash reserves or the credit line.

Encana has fantastic assets and the company could find itself as a takeout target if energy prices go into reverse. However, I wouldn’t buy the stock betting on a buyout, and there are other names in the energy space that are safer investments right now.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Andrew Walker has no position in any stocks mentioned.

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